Don't Go Chasing Waterfalls: Fiduciary Duties in Venture Capital Backed Startups

52 Pages Posted: 9 Nov 2020 Last revised: 31 Dec 2021

See all articles by Sarath Sanga

Sarath Sanga

Northwestern University - Pritzker School of Law

Eric L. Talley

Columbia University - School of Law; European Corporate Governance Institute (ECGI)

Date Written: October 31, 2020

Abstract

We develop a model of venture capital contracting and use it to evaluate an emergent set of judicial precedents in corporate law, which we label the Trados doctrine. In our model, founders hold common stock while venture capital investors hold convertible preferred stock. We show that preferred shareholders have inefficient incentives to liquidate low-valued firms and to continue high-valued firms, while common shareholders inefficiently favor the opposite. The extent of incentive misalignment depends on the firm’s intrinsic and outside valuations, and it is most severe around preferred’s liquidation preference and conversion point. Although legal liability rules can rectify these misalignments, they can only do so categorically when management is obligated to prioritize preferred shareholders’ interests. The Trados doctrine, however, requires the opposite: under Trados, boards must accord primacy to common shareholders’ interests, treating preferred shareholders as contractual claimants. More generally, we offer a precise mechanism for how capital structure, corporate governance, and legal doctrine jointly determine firm value.

Keywords: Venture Capital, Preferred Stock, Fiduciary Duties, Liquidation Preference, Conversion Rights, Contract Design, Corporate Governance, Efficient Breach

JEL Classification: G30, G34

Suggested Citation

Sanga, Sarath and Talley, Eric L., Don't Go Chasing Waterfalls: Fiduciary Duties in Venture Capital Backed Startups (October 31, 2020). Available at SSRN: https://ssrn.com/abstract=3721814 or http://dx.doi.org/10.2139/ssrn.3721814

Sarath Sanga (Contact Author)

Northwestern University - Pritzker School of Law ( email )

375 E. Chicago Ave
Chicago, IL 60611
United States

Eric L. Talley

Columbia University - School of Law ( email )

435 West 116th Street
New York, NY 10025
United States

HOME PAGE: http://www.erictalley.com

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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